Business Times

Losing a major battle in a British Court

Claim against CPC in oil hedging case

Sri Lanka lost a major battle in the oil hedging controversy with Standard Chartered Bank (SCB) winning its US$162 million-with-interest claim for non payment of dues in supplying oil cargoes in the controversial deal. The claim was filed against the Ceylon Petroleum Corporation (CPC) in the London High Court and the judgment was delivered on July 11 by Justice A. Hamblen.

Here are extracts of the 140-page ruling in favour of the British bank:
Because the CPC was required to buy oil on the international market in US dollars, in such significant amounts, it was inherent in CPC's business that it had a price risk based on its need to buy physical oil. In particular, in the present case CPC was exposed to the significant and unprecedented rise in the price of oil that occurred in the period from about 2003 up to late-July 2008.

November 16, 2008 File pic: Officials briefing the media denying the CPC's hedging agreements were wrong. L to R: Clive Haswell – CEO Standard Chartered Bank, Dennis Hussey – CEO Citibank, Amitha Gooneratne – Managing Director Commercial Bank and Asantha De Mel – Chairman CPC. Pic by J. Weerasekera

In an attempt to protect itself from the rise in the oil price, from February 2007 CPC began to enter into oil derivative transactions with the SCB and other competing banks operating in Sri Lanka, including Citibank NA, Deutsche Bank, and two Sri Lankan banks, Commercial Bank of Ceylon and People's Bank (which is owned by the Sri Lankan Government). In the period between February 2007 and October 2008, CPC entered into about 30 such transactions, including 10 transactions with SCB.

All CPC's oil derivative transactions were executed on CPC's behalf by its Chairman, Managing Director and sole executive director, Ashantha de Mel. The transactions were also often signed by Lalith Karunaratne, Deputy General Manager (Finance) of CPC and its chief financial officer since February 2005.

The Transactions were entered into under an ISDA Master Agreement dated as of 31 July 2006.
SCB's case is straightforward: it is entitled to the remaining payments which are due under the terms of the transactions. CPC entered into the Transactions as an arm's length counter-party with SCB, knowing how they would respond to fluctuations in the oil price, wanting to acquire the benefits of the Transactions, and aware of the risks and rewards that they entailed. CPC was always aware that a fall in oil prices (which in this case was largely caused by the financial crisis) would cause it to became liable to make payments to SCB and there is no basis upon which it can now avoid its obligations.

CPC's case is that, when considered in its proper factual context, this is not a straightforward claim, as SCB contends, and that there is nothing standard about this case. On the contrary, this is a case concerning a publicly owned corporation, of critical importance to its national economy, with no experience in commodity derivative transactions, engaging in novel and sophisticated transactions for the first time in a country that itself had no previous experience of such trading. CPC contends that SCB held itself out to CPC as advisor and encouraged it to enter into transactions that did not hedge its risks, but instead provided the prospect of insignificant up-front fixed profits in return for taking on vast and disproportionate downside risk. CPC, which had no appetite to lose money, should never have been sold these products, and it disputes their validity.

CPC advances four main grounds upon which it is entitled to refuse to pay the amounts allegedly due:
n Lack of capacity: CPC contends that it did not have capacity under the CPC Act to enter into the particular derivative contracts that it purported to enter into because: (a) they fell outside the scope of CPC's "general objects"; and (b) they fell outside the terms of a letter dated 29 January 2007 said to constitute a "direction" given by the Minister of Petroleum to CPC pursuant to s 7(1) of the CPC Act.
n Lack of authority: CPC contends that (a) Mr de Mel and Mr Karuanaratne lacked actual authority from the CPC Board to enter into the Transactions because they were in breach of the terms of the relevant board resolution of March 2007; and (b) they fell outside the terms of the Wijetunge letter. CPC also denies that Mr de Mel and Mr Karuanaratne had ostensible authority to enter into the Transactions.
n Supervening illegality: CPC contends that a letter dated 16 December 2008 from the Secretary of the Monetary Board of the Central Bank of Sri Lanka (CBSL) had the effect of rendering any further performance of CPC's payment obligations under the Transactions unlawful in Sri Lanka.
nCounterclaim: CPC contends that SCB owed a contractual and/or tortious duty to advise CPC which it breached, and that it made misrepresentations to CPC, thereby causing CPC to enter into the Transactions, and suffer loss constituted by the payments due under them.

Zero Cost Collar
A transaction involving the purchase of a call option by the customer in consideration of the sale of a put option is sometimes called a Zero Cost Collar or ZCC. Under a simple ZCC, the customer, a purchaser of physical oil, buys a call option from the bank, that is a right to buy oil if the oil price is higher than the 'strike price' of the call option. The strike price of the call option is often referred to as "the ceiling". The customer does not pay an upfront premium for the call option that it is buying (hence the transaction is, in this sense, "zero-cost"), but pays for it by selling a corresponding put option to the bank. Under the put option, the customer must pay the bank if the oil price falls below the strike price of the put option. The strike price of the put option is often referred to as "the floor".

The effect of a simple ZCC is that: (1) If the market price of oil is above the ceiling (i.e. above the strike price of the call option bought by the customer), the bank is required to make a payment to the customer; (2) If the market price of oil is between the ceiling and the floor, neither party is required to make a payment to the other; and (3) If the market price of oil is below the floor (i.e. below the strike price of the put option sold by the customer), the customer is required to make a payment to the bank.

SCB in Sri Lanka
SCB is one of several international banks which has branches in Sri Lanka. SCB's Chief Executive Officer in Sri Lanka at the relevant time was Clive Haswell. Its Wholesale Banking was divided into two parts, namely Global Markets, headed by Rukshan Dias and Corporate Client Relationships, headed by Ms Kimarli Fernando who led a team of relationship managers.

At the trial SCB called the following factual witnesses: Mr Haswell; Mr Peiris; Mr Dias; Mr Casie Chetty; Mr Green; Mr Naik; Mr Bhandari and Mr Raman. CPC called two former SCB employees as witnesses: Ms Fernando and Mr Ozman, who had been Chief Financial Officer of SCB Colombo.

At the trial CPC called the following factual witnesses: Mr Karunaratne; Mr de Mel; Ms Fernando; Ms Wijetunge; Mr Wijegoonewardena, a non-executive director of CPC; Mr Rajakaruna; Mr Abdul Hameed Mohamed Fowzie, the Minister of Petroleum at the time; Mr zman; Mr Ranasinghe, and Mr Nanayakkara, Director, Bank Supervision Department of Central Bank.

A number of presentations were made by SCB and other banks in relation to the potential benefits of hedging during the course of 2006.

De Mel
On 20 August 2007 Mr de Mel and Mr Karunaratne submitted a Board Paper, providing details of, and seeking approval of, the hedging contracts CPC had entered into with each of Citi and SCB, including a reference to the fact that the Citi contracts were leveraged, so that "if the prices go below the floor level CPC has to pay twice". There was a Board meeting on the same day, attended by (amongst others) Dr Thenuwara of the CBSL and a representative of the Ministry (Ms Wijetunge). The Board minute records that at "the onset of the Board Meeting Chairman had a discussion with the members of the board and Central Bank representative Dr Thenuwara … on oil hedging". Later it records that "the Board having discussed the Board Paper gave its approval to the four hedge positions mentioned … in the Board Paper."

There was a factual dispute between the parties as to whether Ms Fernando had concerns about the CPC transactions and the extent to which she shared those concerns with others within SCB. I do not consider that dispute to be of great relevance to the issues in the case. In so far as it matters, I find that Ms Fernando did share some of Mr Green's concerns, but I am not satisfied that she expressed these concerns to any greater extent than is shown by the documentation.

On 8 April 2008, Mr Bhandari met with Mr de Mel in Dubai at Mr Bhandari's hotel, where they had dinner. This was a fairly general conversation about topics ranging from oil prices, hedging strategies and CPC's understanding of the risk. Between 15 and 18 May 2008 Mr de Mel visited SCB's offices in Singapore, including a visit to SCB's dealing room. Mr Haswell and Mr Dias joined him on this visit.
On 7 November 2008, Mr Dhammika Perera (Chairman/Director General of the Board of Investment of Sri Lanka) wrote to Mr de Mel pointing out that he had been informed that "…some of the instruments that the CPC may have entered into, are schemes for investors and are not proper hedges". Mr de Mel replied by letter of the same date denying this. He wrote: "…our hedges are always in the money when we enter into hedge contracts. In order to be in the money and to unhedge as quickly as possible, we have agreed into targeted hedge gains in those contracts".

On 9 November 2008, the Sunday Times of Sri Lanka carried an article entitled "Crisis over oil hedging deals". This asserted, amongst other things, that payments of about $30m due to SCB and Citibank had not been paid by a deadline said to be Friday 7 November 2008. It reported that both banks were due to meet their ambassadors (Britain and United States) to put pressure on CPC to pay.

The report was not entirely accurate: CPC's payments to SCB were not due until 14 November 2008 although a payment to Citibank was due on Friday 7 November 2008, but was not made on that day because Governor Cabraal called Mr Karunaratne to hold payments to the banks for a while.
On 14 November 2008, Dr Ranee Jayamaha (Deputy Governor of the CBSL) wrote to Mr de Mel further to a letter dated 11 November 2008. She wrote in relation to CPC's oil hedging and pointed to an imbalance in risk: "…there is no significant protection available to CPC from the hedging contracts…However there was an unlimited potential loss to CPC on the downward movement of oil prices…". She concluded that:"…The huge downside risk on these contracts has already threatened the stability in the domestic foreign exchange market in the immediate term. Hence it is essential for CPC to take remedial measures immediately…"

Mr Haswell met with Governor Cabraal on 19 November 2008. Governor Cabraal informed Mr Haswell that the CBSL had conducted an independent audit into the transactions, the key findings of which were that the Board was unaware of the structures dealt by Mr de Mel and that Mr de Mel was not given authority to enter into such hedges. The Governor added that the movement in pump prices was determined by the Government, not CPC.

A Ministerial Committee was also appointed on 26 November 2008 to review the derivative transactions entered into by CPC. On the same day, two petitioners petitioned the Supreme Court of Sri Lanka in relation to CPC's derivative transactions under a jurisdiction conferred on the Supreme Court by Article 126 of Sri Lanka's Constitution (the "2008 proceedings"). Their petitions (nos.SCFR 535/2008 and SCFR 536/2008) first came before the Supreme Court on 28 November 2008. In its Order of that date, the Supreme Court held that the petitioners had:-

"…established a strong prima facie case that these transactions have not been entered into lawfully; that they are not "arms length transactions"; that they are heavily weighted in favour of he Banks; that they are to the detriment of the Ceylon Petroleum Corporation and through that to the people of Sri Lanka…"
On 16 December 2008, the Monetary Board submitted a confidential report to the Supreme Court. It also wrote to SCB and the other banks in the following terms (the "Monetary Board Letter"):

"Having considered the above matters, and the interim Order made by the Supreme Court of Sri Lanka on 28 November, 2008 suspending all payments by the CPC to the respective banks on the aforesaid transactions, we find that the above transactions are materially affected and substantially tainted.
In the circumstances, please do not proceed with, or give effect to, these transactions."

Under cover of a letter dated 24 December 2008, the Director of Bank Supervision wrote to SCB enclosing its investigation report on oil derivative transactions entered into by SCB with CPC.
On 27 January 2009, the Supreme Court vacated its interim orders in the 2008 proceedings.
On 27 January 2009, the CBSL issued a press release making clear that the instructions and directions issued by the CBSL to the respective banks on 16 December 2008 continued to be in force.

The problem for Mr de Mel was that a ZCC involved the risk of payments being made to the banks should prices fall. He recognised that that this would be politically unacceptable and indeed the Minister told him that both his job and that of the Minister would potentially be on the line.

In summary, CPC's hedging strategy involved a combination of concerns and considerations and the emphasis between them differed over time and in response to the unprecedented and very difficult market conditions. However, the hedges were all related to underlying physicals and provided protection against both high and rising prices. Although the extent of that protection became limited, and although CPC became increasingly keen to use hedging more for cashflow and foreign exchange generation than price protection purposes, price protection remained an element of its strategy and that strategy never became one that was solely or predominantly driven by speculative profit making.

I find that the Transactions were conducive or incidental to CPC's business of importing, selling, supplying or distributing oil because they were hedges of its petroleum purchases and in particular:
I (also) find that the Transactions were hedges of CPC's purchases of petroleum products and were not speculative.

AUTHORITY - Were Mr de Mel and/or Karunaratne authorised to enter into Transactions 8 and 9 on behalf of CPC?

On the face of it CPC gave Mr de Mel and Mr Karunaratne authority to enter into any individual derivative transactions, to be governed by the Master Agreement.

I further find that in relation to the Transactions both Mr de Mel and Mr Karunaratne bona fide and reasonably believed that they were acting within the authority conferred on them. I therefore conclude that Mr de Mel and Mr Karunaratne did have actual authority to enter into the Transactions.

Little knowledge

It is correct that CPC had little knowledge of derivative transactions in mid-2006 and that it never had proper systems in place to manage and monitor risk. However, both Mr de Mel and Mr Karunaratne became increasingly knowledgeable about derivatives through the various presentations made by the banks, through their own due diligence and as a result of the various trades which CPC carried out. Both well understood the operational features of the trades which they did, including the downside risks.


CPC alleges SCB made misrepresentations or negligent misstatements to CPC as a result of which CPC has suffered loss. Even assuming that SCB had represented that the transactions constituted "a true hedge", that they "formed part of a proper hedging strategy" and that they "were consistent with the Stated Justification", I find that such representations would have been no more than expressions of belief, which would only be falsified by dishonesty, which is not alleged. There would accordingly have been no misrepresentation.

I accordingly find that the alleged misrepresentations were not made and that CPC has in any event not proved inducement. Even if that be incorrect, I find that CPC is contractually estopped from asserting its misrepresentation claim. Its counterclaim founded on misrepresentation accordingly fails.

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